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Why the Dow Makes Little Sense

Don't pay so much attention to this oft-cited index.

"The Dow." It's a presumed proxy of the entire stock market. But many of us don't fully appreciate what it really is -- and what its limitations are.

For starters, while the S&P 500 includes 500 big American companies, and "total stock market" indexes such as the Dow Jones Wilshire 5000 include several thousand, the Dow Jones Industrial Average features just 30.

That's just one of the Dow's shortcomings -- and these days, they're more pronounced than ever. Take the Dow's price-weighting, which means that the stocks in the index with higher prices carry greater weight in caluclating the overall average.

So with IBM(NYSE: IBM) recently trading around $90 per share and General Electric(NYSE: GE) trading around $12, IBM is more than seven times more influential in the Dow -- even though the companies' market capitalizations are both around $125 billion. The stocks that are really moving the Dow around carry the highest prices, such as ExxonMobil(NYSE: XOM), Chevron(NYSE: CVX), and McDonald's(NYSE: MCD). Those with the lowest prices, such as Citigroup, which was recently trading around $3 per share, have almost no impact on it.

Meet the divisorLet me back up a bit to give you a fuller picture. The Dow is essentially the average price of the 30 component stocks. That might seem kind of impossible, since most stock prices we pay attention to tend to be between, say, $5 and $200, and the index has recently been fluctuating around 8,000.

But if the companies in the index had never split their shares, issued dividends, or undergone major changes such as spinoffs or mergers during the time they were listed in the index, their average price would be around $8,000. Take component Coca-Cola(NYSE: KO). In its 90-year history as a public company, if it had never once split its stock, one share would cost more than $200,000 today.

Similarly, Microsoft(NYSE: MSFT) went public in 1986, and it has since split its stock nine times. If you'd bought one single share when the stock debuted, it would have cost you less than $30. But, as of the time of this writing, that single share has become 288 shares, each worth about $17. Total it up, and that initial stake has grown to be worth roughly $5,000.

So how do we get from the current modest stock prices to the Dow's value around 8,000? Well, there's a little trick involved -- called the "divisor." It was recently 0.1255527090. The original divisor -- back in 1896, when the Dow was created -- was just the number of stocks in the average (12). However, to account for stock splits, mergers, and such, the divisor has to be adjusted frequently. (A few years ago, it was 0.14452124.)

Take a component's stock price, divide it by the divisor, and you'll see how many Dow points it represents. Coca-Cola, for example, recently traded near $43, which works out to 342 points in the Dow.

Weird effectsA recent study by Bianco Research noted that financial companies' recent low prices mean those stocks have ceased to have much effect on the Dow. With many financials trading under $10 per share, the Dow would only lose a few hundred points, even if all of them fell to zero.

In addition, there's a good chance that some Dow stocks with Lilliputian prices will get booted out of the index in the near future, because the Dow typically frowns on stocks with prices below $10. When that happens, and the companies are replaced, we can expect the index's dynamic to change -- again.

So what?Well, as you take the pulse of the market in this volatile but exciting time, don't pay too much attention to the Dow. When you see how it's changing from day to day, it's really only telling you how a few stocks have performed.

Also, know that there are other ways to build indexes, other than weighting components by stock price, which usually doesn't tell you too much by itself. The S&P 500 index, for example, is a market-cap-weighted index, giving the companies with the greatest market values the most influence.

Author

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian